AM18 M7 Regulation

Questions

1. Explain why under-writing was replaced by credit scoring, and how this approach failed. Explain why reform would require strengthening underwriting. Explain how this lesson from the GFC applies to SME and Agri Finance in Pakistan.

Answer1 Underwriting is basically a kind of guarantee that this loan is going to be good. Underwriting is usually based on personal judgment and qualitative information. In the past, this personal judgment and qualitative information replaced with external evaluation (credit scoring). The reason behind this replacement is that people considered underwriting as unnecessary flowered and People were impressed by quantitate and numerical measure of risk.

This paradigm is wrong and it has been failed, because numerical measure of risk is biased. Numerical and quantitate measure of risk through credit scoring can be manipulated. Moreover credit scoring eliminates the relationship banking which changes the behavior of lender and borrower this situation means that past default rates become irrelevant.

Government give power of underwriting to banks to make loan safe and sound, this act is in public interest because banks giving money and government authorized them on its own behalf. Reform would require for strengthening underwriting, because if bank cannot do good underwriting then possibility of bank’s money creation disappears and government would directly do the job of lending.

Banks in Pakistan lend to SMEs selectively. They have reasons to do so: about 95 percent of SMEs work in the informal sector means they are not documented. Lending them is far riskier than lending to tax paying individual. Banks keep SMEs and agri finance lending under tight controls. Bank mostly uses underwriting approach when lending to SMEs and agri finance because many of them operate in the informal sector. While, formal bank financing, is mostly based on credit scoring. SME lending, like agricultural finance, requires specialized banking skills. Borrower’s screening must be insured, banks should give loans on the basis of entrepreneurial skills, and bank’s team should visit project site of SMEs in order to make sure that loan is utilizing in targeted area.

2. Private Profits differ from Social Benefits. Explain why loans for some types of investments should be encouraged despite high default rates.

Answer 2: The argument of direct lending by government is even stronger if there is a strong public purpose involved, where relatively high default rates are acceptable. For example in the Unites States, college students’ typically use student loans to pay for education. If college education is highly valued, it might make sense to drop participation of private institutions because careful underwriting is less important. The net value to the society as a whole could be large enough to offset the losses caused by relatively high default rates.

3. Explain why raising credit requirements -- the approach of Basel accords -- may actually increase fragility and risk to the banking system.

Answer 3: Basel accord used risk adjusted weightings for capital requirements to encourage banks to hold less risky assets for which they required lower capital and more risky assets required high capital ratio. But actually this approach leads to increase the risk to the banking system. Suppose there are two banks: bank A has 10% equity and 90% leverage. Bank B has 50 % equity and 50% leverage. Both banks have $100; both banks have equal return on their equity. Bank A has 10% rate of return on 10% equity which is 100% rate of return. Bank B has 10% returns on 50% equity which is 20%. The rate of return is higher for high leverage bank and vice versa. Then bank B move toward riskier investment to make high return. High capital ratios necessarily reduce return on equity. So, it is not necessarily true that higher capital ratios increase safety of banks because it means they are less profitable. Indeed with higher capital ratios they need to choose a higher risk/ return portfolio of asset to achieve a target return on equity.

4. Explain why micro-prudential regulations on bank behavior are not enough; Macro-prudential regulations on the whole system are required. Also explain why such system-wide regulations imposed by Central Banks must keep evolving and changing with time.

Answer 4: Minsk argued that micro-prudential or examining individual bank behavior without attempting to contain the macro environments evolution toward instability would fail to prevent major financial crisis. As regulators had failed to recognize that a number of macro factors had putt the financial system at risk: the high interest rate policy of Volcker, a US commercial real estate bubble, and regional housing bubbles caused by an oil boom. For this reason, it is not sufficient to put in place effective bank examination or micro-prudential regulation but macro- prudential regulation of the system as a whole is equally required. After the GFC, this notion became almost a mantra in the regulatory community.

Central banks need to have their finger on the impulse of the entire financial system. And regulation must evolve. Evolvement of regulation is necessary because market and financial structure evolve over the time. So, In order to make financial practices consistent with regulations, regulations must evolve over the time.